Decision Making for Traders

When trading, I find it easiest to make decisions by ignoring the process. I assume that I am correctly processing the available information, maintaining discipline, and making the best choice under the given circumstances. However, if we think about the steps taken to arrive at a decision, would our trading performance improve? Today's post discusses the decision-making process.

Winning as a trader requires the ability to make good decisions. By my definition that means the decisions must be reasonable and have an acceptable risk/reward ratio, considering the probability of success. It does not refer to whether the decision turns out to be profitable.

We obviously earn our daily bread (or build our retirement account etc.) via profits and losses, and it is a good idea to know which decisions worked and which did not. However, if a trader consistently makes good decisions, he/she would have to be extremely unlucky not to prosper. Thus, we want to make good decisions (I'll bet you already knew that).

Decisions may be simple. Example: Hold or fold. Add to position or maintain current risk level.

Decisions may be complex: Which of (trader: insert your list) these specific adjustments would give me the best position at this time? Are current market conditions right for my current strategy?

We all recognize that luck enters the picture on occasion and good decisions may turn out to lose money and poor choices turn into cash. We live and trade in a statistical universe, and over the longer term, the trader who bucks the odds is unlikely to become a success. Learning to make good decisions is a serious part of the education process.

If you accept that training yourself to become a good decision-maker is important for a trader, then you are also accepting the fact that trader psychology plays a vital role for all traders. Many never recognize this, but the case is made succinctly by Trading Psychology Management:

If you are going to trade, you are going to be affected by psychology – this is the only guarantee from trading that anyone will ever get.

Traders spend so much time searching for that perfect trading system, but they do so little to actually prepare to become a trader – preparation that includes their learning approach, and preparation that includes their mental approach to the emotions and stresses inherent in trading.

Included in the preparation process is doing your best to make good trade decisions. These opportinuties occur frequently: when we open (or decide to pass) a new position, adjust (or decide it's not needed), and exit (or hold longer). However, the typical trader doesn't place enough emphasis on these important steps. It's not enough to decide to adjust a trade. The best decision is made after considering adjusting, holding, folding. Then it includes which specific adjustment to make. Hopefully a trading plan is in place to guide the trader to a good choice.

Denise Schull and her team at Trader Psyches, make an important distinction about trade decisions:

"In many ways, many traders end up shrugging their shoulders to the tune of “oh well I will do better next time”.

The question becomes /what exactly/ will make them perceive, decide and act “better” the next time? I mean it isn’t like there aren’t tons of methods and tools to help a trader with their decision making, their psychology and their emotions."

Isn't this the truth? When we face a bad situation, don't traders tend to believe it was a matter of unfortunate circumstances rather than accepting the fact that a poor decision may be the reason for our current plight? Don't we all want to believe that we were unlucky, (and we are unlucky – part of the time) rather than careless? Don't we believe next time will bring success?

In the same post, they go on to suggest that the trader's tools may be flawed. More specifically, the suggestion is made:

Failure to understand how the human brain makes decisions when facing uncertainty – is that flaw.

An interesting point of view. When facing uncertainty, decisions are made differently. If we had a better understanding of the decision-making process, we could improve the quality of our decisions.

In Don't Take the Wrong Decision Shortcuts, Steven Martin writes about the importance of going about the decision-making process. The objective is to place yourself on the right side of the probability scale. I've simplified a few conclusions below:

Having all pertinent facts is critical to good decision-making, but conflicting information (information overload) can leave us uncertain.

Behavioral scientists found: As decision complexity increases, we rely on less information to decide and often use a single rule of thumb as a reliable shortcut to making a good decision.

Two such "decision shortcuts" are:

Social proof. One very efficient route to a good decision is to look at how many others are making the same decision: if everyone else is buying it then perhaps I should too.[MDW: The herd mentality. For traders, this is NOT an efficient decision]

Uniqueness suggests that we should be persuaded by singular features offered in a proposal: if this is the only car with heated seats, I should buy it! [MDW: This requires the confidence to trust your own judgment]

These conclusions don't seem to apply to traders. As Schull points out, the difference may be due to a large level of uncertainly about the future. Martin is referring to more ordinary daily activities.

Intuition

Have you ever wanted to make trade decisions based on intuition? Dr. Brett offers a short commentary on this topic. He sees the possibility for doing this effectively, but believes that special study may be required. Intuition is a common method used for making decisions among traders who don't have the discipline to adhere to a consistent method. Traders are human and resisting an intuitive feeling is difficult.

If your 'hunches' don't add money to your account, it becomes important to fight the impulse to play those hunches. Discipline is required.

Sunk costs

A stock trader offers this argument (rephrased): It is difficult to ignore sunk costs (money spent, or lost, up to the present time) and have the discipline to make sound decisions regardless of the time and money spent to date. As a trader think about the losing position that you simply do not want to sell - because you are emotionally attached to the trade. Perhaps this is your favorite stock or option strategy, perhaps you did extra research before placing the trade. Maybe you love the management of the specific company and cannot believe the stock price is declining.

However, it is just not smart to maintain the position because of sunk costs.

Winning traders think differently. They see a losing position as another trade gone bad. They exit losers with no hard feelings.

Can we do better by understanding the decision process? Or are we well served by applying the principles we know ,and trust them to work for us? Perhaps it takes an insightful personality to answer these questions.

3 Responses to Decision Making for Traders

Mark,
I was surprised that you didn’t address the importance of developing and applying a well-defined decision-making process.
Without a well-defined decision-making process, with rules (or at least guidelines), investors often succumb to allowing their emotions to rule (seat-of-the-pants decision making) — rather than having their rules direct their choices and thus minimizing the often destructive result of a largely emotionally-driven decision.
Your thoughts on this?
Jeff

Jeff,
Thanks for correction.
I agree that it’s important to get emotions out of trade decisions. That’s one reason for having a trade plan – for each existing position – in place.
I agree, developing a well-defined process for making decisions is every trader’s goal. In this post I want to be certain that rookies understand that point.
As far as achieving the goal, I’m not sure how to provide the needed advice. I would include:
a) Consider alternatives. This is a fairly obvious inclusion. How to be certain that all reasonable alternatives are considered – in a reasonable time – is a more complex story.
b) Need for speed. Often, especially when no plan is in place, a quick decision is required because money is being lost (or risk is increasing) at a rapid pace.
Thus, understanding whether making a reasonable trade right now is more important than taking a few minutes to find a better trade, is not something that can be readily explained. In fact, my thought is that this is 100% dependent on the comfort zone of the trader.
More than that, it’s the comfort zone dictated by current fear (yes, the emotion we want to avoid) that determines how quickly to make a trade. This is a strong argument for advance planning – even though those plans may not be applicable when needed. Thus, I’d also include: update those plans frequently – as part of the process.
c) It’s definitely easier to find a new trade than to manage a losing trade because the decision-making plan is NOT as timely. If an opportunity exists, it should still be there in a few minutes – depending on the strategy employed. If it’s simply a get long or get short play, then the decision is simpler.
Jeff, I don’t truly know how to describe the process in enough detail to suit a majority of traders. To me this is as important as learning to trade. It comes with a myriad of alternatives, warnings about emotional trading, and ideas about how to choose a good alternative.
If you’ve written, or read some good ideas on this topic, I’d appreciate a reference.
Thanks
d)